Chapter 1: Investments - Background and Issues Flashcards
What is an investment?
A commitment of current resources in the expectation of deriving greater resources in the future.
You sacrifice something of value now, expecting to benefit from that sacrifice later.
What is a real asset?
Assets used to produce goods and services. Real assets determine the wealth of an economy.
Ex.: land, buildings, equipment, and knowledge.
What is a financial asset?
Claims on real assets or the income generated by them.
A household financial asset (e.g. debt security) is a liability of the company that issued it. Financial assets merely represent claims on real assets. They allow us to make the most of the economy’s real assets.
Ex.: stocks, bonds
Are the following assets real or financial?
a. Patents
b. Lease obligations
c. Customer goodwill
d. A college education
e. A $5 bill
a. Patents - Real
b. Lease obligations - Financial
c. Customer goodwill - Real
d. A college education - Real
e. A $5 bill - Financial
What is a fixed-income or debt security?
Promise a specified cash flow over a specific period. It may be fixed stream or a stream of income determined according to a specified formula.
What is the money market?
Refers to fixed-income securities that are short-term, highly marketable, generally very low risk (e.g. U.S. Treasury Bills).
What is the capital market?
Refers to long-term securities such as Treasury bonds, as well as bonds issued by federal and other government agencies, and corporations. These may be relatively safe or relatively risky.
What is equity?
An ownership share in a corporation.
What are derivative securities?
Examples include options and futures, where the payoffs are determined by the prices of other assets such as bond and stock prices (i.e. derivatives are ‘derived’ from the prices of other securities). The primary use of derivatives is to hedge risks or transfer them to other parties – sometimes they represent huge risks that amount to major losses, but generally, they are good for managing risk.
What are some of the ways that financial assets allow us to make the most of real assets?
- Informational role (i.e. a firm’s current performance and future prospects)
- Consumption timing (i.e. ‘store’ your wealth in financial assets so that you are not making more money than you wish to spend or spending more money than you earn)
- Allocation of risk (i.e. all real assets involve some risk, but financial assets allow the most risk-tolerant people to take on those risks, while the least tolerant can take on relatively little risk)
- Separation of ownership and management (i.e. avoid agency problems, conflicts of interest between managers and stockholders, including compensation plans, ousting under-performers, or the threat of takeover)
- Corporate governance and ethics (i.e. increase transparency, though there are many instances where this has not been the case)
What is a portfolio?
A collection of investment assets
What is asset allocation?
Allocation of an investment portfolio across broad asset classes.
What is a security selection?
It is a choice of specific securities within each asset class
What is the risk-return tradeoff?
Assets / securities with higher expected returns are priced accordingly.
What are passive and active management of portfolios in the context of efficient market hypothesis?
Passive management refers to buying and holding a diversified portfolio, without attempting to intervene, where active management attempts to identify mis-priced securities or to forecast broad market trends.
